Trading View (next 2-4 weeks): We like to be bearish ethereum.
Investment View (next 1-3 years): We like to hold ethereum.
- The Fed will likely announce more aggressive hiking on Wednesday.
- The ethereum correlation with tech stocks is starting to rise again, currently around 57%.
- The probability of a recession exceeds 50%.
- The macro backdrop is bearish for ethereum.
- We have five bearish signals and two neutral signals this week.
- With the macro backdrop bearish and on-chain/flow metrics very bearish, our overall signal is more bearish ethereum (Chart 1).
Macro: Hikes? Yikes! The Meltdown in Crypto
Friday’s hotter-than-expected inflation data has sent stocks and crypto tumbling. May CPI for the US came in at +8.6% vs +8.3% expected. Ethereum is currently amid a cumulative drawdown of around 75% since November highs and trading at around $1,200 – its lowest level since January 2021 (Chart 2).
The main reason for the fall is the Federal Reserve’s response to inflation. It will decide interest rates on Wednesday, and markets are increasingly digesting the prospect of a more aggressive hiking path. We expect 75bp after the Fed announced last night through various reporters, including WSJ’s Nick Timiraos, that 75bp was likely.
Other factors are contributing to the crypto meltdown too:
- Rising yields have mechanically increased the probability of a recession within the next 12 months to over 50%.
- Inflation remains at the forefront of investors’ minds, with PPI and retail sales data also due this week.
- Celsius, one of the biggest crypto lending platforms, has stopped all transactions and withdrawals due to ‘extreme market conditions’.
- MicroStrategy Inc, a large investor in bitcoin that has accumulated over 129,000 bitcoins over the past two years, faces a margin call if bitcoin falls below $21,000. It is currently trading around $22,000. The investor would be obligated to sell some of its bitcoin holdings should such an event happen, though CFO Phong Le has said that adding more collateral to its loan could avoid that situation.
- Binance, one of the largest crypto exchanges, temporarily halted withdrawals amid the crash.
- Coinbase exchange announced it is cutting over 1,000 employees. CEO Brian Armstrong cited changing economic conditions, recession risks, and growth problems as some of the reasons for the changes.
Metrics Review, Part 2: How Does PnL Effect Ethereum Returns?
Following last week’s report on the relationship between exchange flows and bitcoin returns, this week, we turn to profit and loss metrics to see how they relate to ethereum returns.
One of our on-chain metrics is profitability of the coin supply. We usually consider three kinds: the percentage of supply in profit (PSIP), the net unrealised profit/loss ratio (NUPL), and the spent output profit ratio (SOPR) – the Appendix details each.
Qualitatively, we can judge how these metrics relate to crypto returns. For instance, if more of the supply is in profit, this could be bullish for crypto. But does that relationship hold empirically?
High NUPL = Greedy Investors?
We find that each of the three PnL metrics are stationary (no trend in the mean, etc.). Therefore, we regress ethereum 30-day forward returns on PSIP, NUPL, and SOPR from 2015 onward.
We find that:
- The coefficient is positive and significant for PSIP. The positive coefficient on PSIP is intuitive – more profitability of the supply relates to higher returns.
- The coefficient is negative and significant for NUPL. That is, higher net unrealised PnL corresponds to lower forward returns. Why? Perhaps when unrealised returns are high, investors are greedy and ultimately do not realise profits quickly enough before prices start falling again.
- The coefficient is near zero and insignificant for SOPR. The signal itself is very noisy and it contains outputs with a very low lifespan (e.g., just an hour), so SOPR corresponds poorly to returns. To improve this metric, we could ignore outputs with a lifespan below a certain age. An alternative metric, adjusted SOPR, calculates SOPR ignoring all outputs with a lifespan of under an hour – this may be more suitable.
This is a quick and simple way to understand the relationships. But we stress we are only looking at linear relationships here – there could be non-linear interactions at play that are not being modelled by a simple linear regression. We will utilise machine learning methods in future instalments to help explain these.
On-Chain/Flow Metrics: TVL in DeFi Plummets
We have two neutral signals this week:
- Outflows continue to meet inflows for ethereum ETFs.
- Little change in the HODLer vintages.
The remaining signals are all bearish:
- Bias for exchange inflows.
- Decreasing futures open interest and perpetual funding rates.
- Reduced profitability of the coin supply and realised losses on chain.
- Hash rate and miner revenues decline.
- Ethereum’s TVL in DeFi decreasing.
On balance, on-chain/flow metrics are giving a very bearish signal for ethereum. Here are the details of each metric (with explanations in the Appendix).
Institutional Demand: Neutral Ethereum
Our preferred metric to track institutional demand is flows into ethereum ETFs. Flows have been choppy recently as outflows continue to meet inflows (Chart 3). Right now, we are seeing inflows again, but we want to see sustained inflows/outflows for a meaningful period before confirming a bullish/bearish signal. Therefore, we view this as neutral for ethereum in the short term.
Demand for Liquidity and Exchange Activity: Bearish Ethereum
A bias for exchange inflows exists – net 123,000 and 175,000 coins entered exchanges over the past seven and 14 days, respectively (Chart 4). This is bearish ethereum.
Longer term, the 30-day change in the exchange balance reveals fluctuations in the supply held on exchanges month on month. After being positive since 2 June, this metric has entered negative territory again – though only just (Chart 5). In our latest bitcoin update, we investigated the relationship between exchange flows and crypto returns – the punchline was that exchange inflows are bearish for crypto.
Overall, we view these metrics as bearish for ethereum.
Futures Activity: Bearish Ethereum
Futures open interest maintains its downtrend – it is currently $5.6bn, down 5% and 6% over the past seven and 14 days, respectively (Chart 6). Around $4.2bn (75%) of this comes from perpetual futures contracts. That is down 1pp since our last ethereum update.
Perpetual funding rates reveal the directional bias of investors. On average, they have been in a downtrend since last Thursday (Chart 7).
Overall, futures open interest is falling, and funding rates are decreasing: this is bearish ethereum.
HODLers: Neutral Ethereum
The 30-day moving average of the coin days destroyed (CDD) has been trending down since our last update (Chart 8). This suggests less distribution of older coins.
However, splitting HODLers into those who have held for under one year and those for one year or more reveals some older hands are selling as the 1y+ vintage decreases slightly (Chart 9).
On balance, we view these HODLer metrics as neutral ethereum.
Investor Profit and Loss: Bearish Ethereum
On profitability of the coin supply:
- The percentage of circulating supply in profit (PSIP) is now 48% (Chart 10) – down 5pp over the past 14 days.
- Net unrealised profit/loss (NUPL) is -0.1 (10% of market cap) (Chart 11). This means that the overall ethereum supply is now in a period of unrealised losses. In other words, the total value of the supply at the price at which the coins were last moved (realised cap) is less than the current value of the supply (market cap). The last time NUPL was negative was on 26 May 2020. This is a capitulation sign.
- Realised losses prevail on chain. Spent output profit ratio (SOPR) (price sold divided by price paid) has remained below one (net losses) since 16 May (Chart 12). Looking at the past 30 days, 29 days have seen net losses.
Overall, these realised and unrealised profit and loss metrics are bearish for ethereum.
Mining Activity: Bearish Ethereum
The hash rate continues to decline. It is down 3% over the past 14 days (Chart 13). Miner revenues have also plummeted – down 30% and 15% over the past seven and 14 days, respectively (Chart 14).
Decreasing hash rate and lower miner revenues are bearish for ethereum.
DeFi: Bearish Ethereum
Our latest Crypto Index Tracker revealed our DeFi Index is leading losses. It is down 8%. The total value locked (TVL) in DeFi across all protocols is currently around $88bn – down 20% over the past 14 days.
All chains in the top 5 by TVL are down significantly in terms of their TVL on the week (Charts 15 and 16). Ethereum TVL is down 21%. Tron’s TVL is down the most at 28%.
This is bearish for ethereum.
We have introduced a framework for understanding the flow and microstructure dynamics of ethereum markets. The seven key metrics are:
- Institutional demand: outflows meet inflows for ethereum ETFs. Neutral ethereum.
- Liquidity demand: bias for exchange inflows. Bearish ethereum.
- Futures activity: futures open interest and perpetual funding rates in a downtrend. Bearish ethereum.
- HODLer behaviour: less older coin spending, but the overall proportion of the coin supply holding for a year or more is still 60%. Neutral ethereum.
- P&L of investors: decreased profitability of the coin supply, a state of net unrealised losses, and a bias for realised losses on-chain. Bearish ethereum.
- Mining activity: hash rate and miner revenues are down. Bearish ethereum.
- DeFi activity: TVL of ethereum is down 21% on the week. Bearish ethereum.
Perhaps the largest institutional vehicle for ethereum is the Grayscale ETHE Trust, with over $27bn in assets. It invests solely in ETH, and so many investors, notably institutional, who cannot hold ETH directly can get exposure through investing in Grayscale. Consequently, if the trust trades at a premium to ETH prices, it may imply ‘excess’ demand from institutions, but ‘excess’ supply if it trades at a discount. Alternatively, the discount may suggest investors have found other ways to get exposure to ETH, whether through ETFs or directly holding ETH. We therefore focus on how the discount has changed in recent months to gauge investor interest. Alternatively, investors may be using other vehicles to get exposure such as ETFs or holding ETH directly. We put more weight on ETF flows than the Grayscale premium.
Another measure of cryptocurrency bullishness is whether investors are willing to hold it in illiquid form (e.g., a private wallet) or prefer a liquid form (e.g., on an exchange). The former would suggest investors are bullish, as they are comfortable with being unable to sell easily. Conversely, holding it in liquid form would suggest investors are bearish, as they prefer being able to sell easily.
Therefore, large flows onto crypto exchanges would suggest investors want to convert their holdings to a more liquid form, implying more bearishness.
We track the growing market of ethereum futures. Open interest – the sum of long and short contracts – is a good measure of investor interest.
Perpetual funding rates reveal the directional bias of investors. Exchanges set funding rates to prevent a lasting divergence in the price of the futures contract and the underlying since perpetual contracts have no expiry date so never settle in the traditional sense. Consequently, we can interpret funding rates as the cost of holding ethereum via perpetual futures. Positive funding rates imply longs pay shorts and vice versa. We use it as a proxy for trader sentiment since a positive funding rate implies traders are paying a premium to keep open long positions.
In our introductory bitcoin flow framework, we explained ‘HODLers’ and ‘HODLing’. HODLing refers to buy-and-hold strategies in the context of bitcoin and other cryptocurrencies. Those who HODL for extended periods are die-hard adherents.
We can categorise HODLers by the length of time they have held ETH. We define long-term or staunch HODLers as those who bought ETH five or more years ago and have held it ever since, medium-term HODLers as those who bought 6-12 months ago, and short-term HODLers as those who bought 3-6 months ago.
The coin days destroyed (CDD) metric is defined as the number of coins in a transaction multiplied by the number of days since the coins were last spent. So, increasing CDD suggests older coins are being spent (more coin days are destroyed) and vice-versa.
Profit and Loss
- The percent supply in profit (PSIP). This tracks the share of circulating ETH supply in profit. That is the percentage of circulating ETH whose current price is higher than when it was last transacted (movement).
- Net unrealized profit and loss (NUPL). This is the ratio of unrealised profits over total market capitalisation. While PSIP just focuses on whether ETH coins are in profit or not, the NUPL focuses on the size of profits. So, we could have a situation where the PSIP is low – that is, a low share of supply is in profit – but the NUPL could be high if the size of those profits is large.
- Spent output profit ratio (SOPR). While PSIP and NUPL focus on unrealised profits or mark-to-market, this measure focuses on realised profits. SOPR is the realised value of a transaction divided by the value at initiation (or creation) – more simply, price sold divided by price paid. If SOPR is above one, investors in aggregate have realised profits, while below one means they have realised losses. In broad uptrends, SOPR spends a significant amount of time above one, whereas the opposite is true for broad downtrends.
When SOPR is rising, sellers are increasingly realising profits. The opposite is true when it is falling. A price rally with a flatter SOPR trend indicates investors are not yet realising their profits with the rally. The reluctance of investors to sell and realise a profit may be because they believe the price will increase further, which would be bullish. At the same time, more profit taking could precede a correction. Typically, buying as SOPR moves around one during bullish periods has proven to be a profitable strategy.
Computing power is central to the crypto market. Miners use advanced computing hardware to solve complex problems that confirm ETH (and other coins) transactions on the public ledger or blockchain. The miners are rewarded with new coins for their efforts. A measure of the complexity of the problems and so the computing performance required to solve them is the hash rate. The higher this rate, the more computing performance is needed to maintain the blockchain. The rate can fluctuate depending on demand for crypto.
We track the total value locked (TVL) in decentralized finance (DeFi) – the sum of all assets deposited in DeFi protocols, many of which use ethereum as the underlying protocol. The more DeFi products are created, the more ethereum gets locked into the DeFi system and removed from the broader market. This reduction in supply should lead to higher ethereum prices.
Dalvir Mandara is a Quantitative Researcher at Macro Hive. Dalvir has a BSc Mathematics and Computer Science and an MSc Mathematical Finance both from the University of Birmingham. His areas of interest are in the applications of machine learning, deep learning and alternative data for predictive modelling of financial markets.
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.